The difference between UK and EU disclosure regulation on ESG investments could lead to a growing division between domestic and foreign funds and firms.
Ever since Brexit the UK has been keen to differentiate itself from the EU and the financial regulation on ESG disclosure regulation is no exception. ESG investing, which stands for environmental, social and corporate governance, is a rapidly growing part of finance. Consumers are growing more conscious of where their money goes and the positive impact it can have. This leads many investors to regard sustainable companies as more future proof, often leading to those companies receiving a premium valuation. Similarly, savers are also more conscious of the impact their money has on the world, especially younger savers, who will continue to invest for many years. These trends undoubtably contribute to ESG and green funds often out preforming their traditional counter parts.
Most major investment sites now offer ESG ETFs (exchange traded funds) and mutual funds. Most notably Vanguard offers four ESG funds and one ESG bond, while iShares by BlackRock also offer four ‘Paris-Aligned’ funds. ESG investing is no longer a niche investment segment as by 2018 they had already accounted for $30.6 trillion of investments, which is predicted to increase to $53 trillion by 2025, according to Bloomberg. That’s over a third of total assets under management globally. With the size of the market so large and still growing, the regulatory framework around ‘ESG disclosure laws’ is now almost synonymous with regulatory framework around ‘disclosure laws’. Therefore, the divergence between laws in the UK, EU and other countries could have major impacts on finance going forward.
The regulatory framework for ESG finance in the EU is the Sustainable Finance Disclosure Regulation (SFDR), which came into effect 10th March 2021. The three broad categories that must be satisfied for a fund to be classified as sustainable are that it “(i) contributes either to an environmental or a social objective; (ii) does not significantly harm any environmental or social objectives and (iii) where the investee company follows good governance practices”. To satisfy these broader categories other details must be disclosed such as how sustainability risk will be integrated into investment decisions and advice. Sustainability risk is an ESG event that has the potential to reduce the value of an investment, if it happens. Furthermore, funds must disclose how their investment decisions affect their sustainability factors. These include indicators on their impact on the climate and environment; social and employee matters (with respect to human rights); anti-corruption and antibribery policies.
ESG finance in the UK is regulated by the Financial Conduct Authority (FCA), which regulates the rest of the financial market. The FCA classes funds into 5 segments from least sustainable to most sustainable. The first category is for products “not promoted as sustainable”, where funds have not integrated sustainability into investment decisions. “Responsible” investments are where ESG integration is considered but have no specific sustainability goals. “Transitioning” funds are the first class to be considered sustainable. They “aim to influence underlying assets towards meeting sustainability criteria”. “Aligned” funds have more sustainable products and most of their assets are verifiably sustainable. Finally, the highest category is “impact” where products have the objective of being net positive socially and/or environmentally.
One of the main differences between UK and EU regulation is that the EU considers the sustainability of the product investment strategy, not the internals of the organization itself, unlike the FCA does in the UK. This difference, as well as the difference in groupings in the UK system, can lead to funds consisting of the same investment having different classifications in the two regions, complicating investing in ESGs. This is the opposite of what the regulation aims to achieve.
Currently the EU laws apply to EU firms and UK based firms operating in the EU, while the UK laws apply to firms that are regulated by the FCA. This means that the UK based firms operating in the EU can have both laws apply to them, possibly reducing the financial cooperation between the two regions due to the increased red tape. One element of the regulations that binds them together, however, is their basis on the Paris Climate Agreement, which could see further changes to these recent laws come to resemble each other more.